What Does It Mean To Buy An Equity Index ETF?
In a recent webinar, I showed that equities had outperformed all other asset classes like bonds, and generated life-altering wealth over long periods.
Someone then asked: ‘This is a fantastic result of investing in equities. But, how can I believe this data given that the average life of a company is around 20 years. If I had bought some stocks long ago, some of them would have died or disappeared. I am not sure that I would have done so well with equity investing given these failures.'
The question is correct but this conclusion is completely wrong.
The misinterpretation comes from not understanding how an equity index works. Therefore, I wanted to share my answer here so others can also benefit.
Let's take the S&P 500 index. It represents around 85% of the market capitalization of all US-listed stocks, so nearly the entire US stock market.
The index is constructed as follows:
- The S&P committee lists all US-listed stocks and sorts them in descending order of (adjusted) market capitalization.
- They then take the top 500 stocks and include them in the index.
- The percentage weight of each stock in the index is determined as the market cap of that stock divided by the total market cap of all 500 stocks.
This is done every quarter. The adjustments relate to liquidity (float and volumes, which I will skip here for brevity).
So, if you had bought an S&P 500 index ETF in 2000 and held until 2022, $100k invested would have turned into over $300k in value, an excellent result.
Here is how your money would have actually gone to work in that time:
- In 2000, a fifth of your money would be invested in Microsoft, Cisco, Exxon Mobil, GE, and Intel, in that order, accounting for 18% of the index.
- In 2022, a quarter of your money would be invested in Apple, Microsoft, Amazon, Alphabet, and Tesla, accounting for 23% weight in the index.
As Cisco and GE declined over time, the dollar exposure to those two stocks in your ETF would have reduced and your dollar exposure to Apple and Alphabet would have increased.
As some stocks declined over time, your exposure to them would have proportionally reduced and vice versa. The annual portfolio turnover of the S&P 500 has averaged around 4.5% (or 22 years life of a particular stock in the index).
That 100k turning into over 300k is a real result that you can cash out with. Investing through this index would have actually delivered this wealth appreciation, irrespective of whether or not some stocks declined, disappeared, or emerged.
At GFM Focus Investing, we invest with the aim of doubling money every 3-6 years, vs. a double over 9-10 years for the stock market on average. Over a 10 year horizon, the difference in wealth appreciation is huge. Please see this video, 46:50 timestamp, for a snippet of our approach.